Will XLF Reap the Fed’s QE3 Bounty?

Recommendation: Buy XLF for near-term uplift from QE3; one-to-two-month hold.
Options Alternative: Buy to open the XLF October 17 Calls for 10 cents or less.

The Federal Reserve has provided more stimulus[1] — so how should you go about taking advantage of it, with the S&P 500 already having climbed 8% in the past few months? Throw in the fact that the Dow is near 5% of its all-time high of 14,164, and many former bargains are now relatively pricey.

Even before the Fed announcement, implied volatility[2] was at lows last seen in January 2007. But now with QE3 official, it is lower still. This could be indicating a) that further upside across the broader market may be limited, and b) any events causing a spike in volatility could bring big down days along with it. So what sectors might be relatively more bullish and provide better downside protection as a result of the Fed’s actions?

Housing Recovery Gains Steam

In early June, the SPDR S&P Homebuilders ETF (NYSE:XHB[3]) was trading near 20.77 and the data coming in from the sector was promising but far from convincing[4]. In the intervening months, however, the data has strengthened and XHB has followed suit, trading at $25.61 at the time of writing. Over the past year, homebuilders have been the top performing subsector of the S&P 500: +88% compared to the index’s +14.23%.

While the data has gotten more compelling, homebuilding stocks — like the market in general — are possibly pricing in more of a future recovery than the current data shows. Taking advantage of companies whose stocks have not yet seen the multi-year highs put in by homebuilding stocks might allow you to ride the housing recovery trends while still leaving room for appreciation.

But don’t look at companies like Home Depot (NYSE:HD[5]) or Whirlpool (NYSE:WHR[6]), either of which you would naturally consider downstream beneficiaries of a housing recovery. HD is up almost 72% this year alone while WHR has rallied 57% (besides the fact that both companies already make up part of the XHB portfolio). The market has rallied these names right alongside the homebuilders.

The Fed: Benefactor to Financials

Instead, look even further downstream to the sector that historically has performed the best following Fed QE actions: financials like Select Sector SPDR-Financial (NYSE:XLF[7]).

Click to Enlarge Given the increasing fiscal cliff anxiety, Fed-induced bullishness might soon disappear. Focusing on financials allows you to take advantage of central bank largesse while at the same time minimizing downside risk due to the burgeoning health in the U.S. housing market.

As such, entering XLF is a one-to-two-month trade, not a long-term hold.

While thrifts and mortgage finance companies make up less than 1% of XLF’s holdings, it is the diversified services, commercial banks, insurance companies and REITS that are poised to benefit[8] from an expanding portfolio of new mortgage loans and a gradual rise in home prices.

A Surge of New Mortgages?

The loan portfolios of commercial banks could use more than a bit of aid in the form of rising home prices. Plus, record-low mortgage rates[9] — combined with banks’ willingness to ease up their strict lending criteria — have been prompting a wave of new loan applications and refinancings. For example, Wells Fargo’s (NYSE:WFC[10]) mortgage applications were up 90% over the year-ago period, and second-quarter purchase volume was up 43% over Q1. Given that community banking accounts for more than 60% of WFC’s revenue, these statistics bode well for the stock prices in the sector if the housing recovery continues.

Keeping rates low also will be a boon to finance stocks, but whether QE3 actions — which are resulting in negative real interest rates (nominal rates less inflation) — will promote bad investments in housing or prop up artificial demand is an important debate. Many argue that this medicine isn’t so different from the toxin that contaminated the housing market in the first place.

The different sides of that debate will have to be worked out in a different forum — as of now, the Fed has become an inexorable part of how the market is evaluated and how opportunities are appraised. The long-term effects of QE3 may or may not be great for your portfolio, but the short-term effect should be kind to XLF.

So, to reiterate the trade:

Recommendation: Buy XLF for near-term uplift from QE3; one-to-two-month hold.
Options Alternative: Buy to open the XLF October 17 Calls for 10 cents or less.

For option traders, there is no need to go out longer than one month, two at max. The Oct 17 calls on XLF are trading at $0.04 x 0.05 — a speculative trade, but one that could pay off nicely if history repeats itself from prior QE announcements.